Statement of the Hon. Richard Blumenthal, Attorney General, Connecticut Attorney General's Office
Testimony Before the Subcommittee on Select Revenue Measures
of the House Committee on Ways and Means
Hearing on Corporate Inversions
June 25, 2002
I appreciate the opportunity to speak on the issue of corporate inversions, a hyper-technical term for corporations exploiting tax law loopholes and corporate directors and management profiting and protecting themselves from proper accountability.
I urge your support for legislation such as HR 3884, the Corporate Patriot Enforcement Act that would permanently close a loophole in our laws that permits corporations to abandon America and abrogate their moral responsibility to this country.
When I was first scheduled to speak on June 6, 2002, I intended to quote at length from a speech delivered only the day before by Henry Paulson, chairman of Goldman, Sachs, who expressed alarm that American business has never been held in lower repute. Now, even more clearly, we know that one major reason for such low repute is this type of tax avoidance loophole.
Long-time American corporations with operations in other countries can dodge tens of millions of dollars in federal taxes by the device of reincorporating in another country. How do they become a “foreign company” and avoid taxes on foreign operations? They simply file incorporation papers in a country with friendly tax laws, open a post-office box and hold an annual meeting there. They need have no employees in that country or investments in that country—in short, no financial stake there at all. It is a sham, a ‘virtual’ foreign corporation – and our tax laws not only allow this ridiculous charade, they encourage it. This loophole is a special exception run amok. It is a tax loophole that must be slammed shut.
Bermuda may seem close geographically and familiar in language and customs, but it might as well be the moon in terms of legal rights and protections for shareholders. In pitching reincorporation, management has repeatedly misled shareholders – failing to reveal the real long term costs, and concealing even the short term financial effects.
Connecticut has learned this lesson the hard way from Stanley Works -- the most recent and potentially most notorious corporation to attempt to avoid taxes through this corporate shell game. Stanley Works is a proud American company that is based in the industrial town of New Britain, Connecticut. For more than 150 years, it has manufactured some of the best-known American-made tools.
Over the past 20 years, sadly, it has moved much of its manufacturing overseas where cheaper labor means more profits. In fact, it has moved so much of its operations that it was in danger of losing its ability to claim that its products were made in America, a major selling point. Several years ago, it supported an attempt to weaken the standards for claiming products are “made in the USA”. This proposed rule would have allowed corporations to use the “made in the USA” label on products that were mostly made in other countries, with only the finishing touches applied here. It was nothing less than an attempt to create the ‘veneer’ of American craftsmanship. Along with others, I strongly opposed this weakened standard and it was eventually withdrawn.
Now, this same company is seeking to sell its American citizenship for $20-30 million pieces of silver. Reincorporating in Bermuda would render hundreds of millions of dollars in profits from foreign divisions tax-exempt in the United States. Stanley Works, of course, is not the only company to use this tax law loophole. Cooper Industries, Seagate Technologies, Ingersoll-Rand and PricewaterhouseCoopers Consulting, to name but a few, have also become pseudo-foreign corporations for the sole purpose of saving tax dollars.
While profits may increase as a result of this foreign reincorporation gimmick, there are some significant disadvantages to shareholders that may not be readily apparent to them. Shareholders must exchange their stock in the corporation for new foreign corporation shares– generating capital gains tax liability. So while the corporation saves taxes, employees and retirees who hold shares are now unexpectedly facing significant capital gains tax bills. Some must sell many of the new shares in order to pay the capital gains tax—reducing the dividend income they were counting on for their retirements.
At the same time, corporate executives and other holders of thousands of shares of the corporation will receive huge windfalls from stock options as the stock price rises because of increased profits. Stanley Works estimates that its stock may rise by 11.5% after re-incorporation in Bermuda. That increase produces a $17.5 million gain in CEO John Trani’s stock option value while shareholders are facing $150 million in capital gains taxes. Smaller shareholders, of course, do not have huge stock option gains that they can use to pay the capital gains tax.
Incorporating in another country may also restrict shareholder rights and protections because foreign laws are far weaker than ours. This issue is not apparent to many shareholders because they may look at re-incorporation as a merely technical move with only corporate tax implications. The company’s headquarters remains in the United States so shareholders may think that American laws will still apply. Management has hardly rushed to clarify the weakening, even eviscerating of shareholder rights.
Taking advantage of corporate tax loopholes, corporations like Stanley Works typically reincorporate in Bermuda. Bermuda law differs from the corporate law of most states in several very important respects.
First, there is the simple problem of the opacity of Bermuda law. Even sophisticated shareholders may have extreme difficulty in obtaining information about Bermuda law and evaluating the impairment of their rights under Bermuda law. Bermuda does not even maintain an official reporter of its court decisions. We have learned from the Enron scandal the danger for shareholders, employees and regulators of shielding important corporate information from public scrutiny. The movement of corporations to a place where the legal rights of shareholders are severely constrained and confused – indeed at best unclear -- is a matter of grave concern.
Corporations proposing to reincorporate to Bermuda, such as Stanley, often tell shareholders that there is no material difference in the law. But what we have learned about Bermuda law—and divining Bermuda law is no easy task—shows this claim is certainly not accurate. There are several important aspects of Bermuda law that greatly diminish shareholder rights.
For example, Bermuda law lacks any meaningful limitations on insider transactions. Like most states, Connecticut imposes significant restrictions on corporate dealings with interested directors of the corporation – the kind of restrictions that appear to have been violated in the Enron debacle. Those protections appear to be absent under Bermuda law.
Bermuda law also fails to provide shareholders with decision-making authority on fundamental changes in the corporation. Connecticut law, like statutes of most states, requires that shareholder approval be obtained before the corporation may sell or dispose of a substantial portion of the assets of the corporation. Bermuda law contains no such requirement.
Similarly, Bermuda law permits shareholder derivative lawsuits in only very limited circumstances. Derivative lawsuits are an essential protection for shareholders. In the United States, shareholders may bring actions on behalf of the corporation against officers and directors seeking to harm the corporation. The availability of derivative lawsuits is a profoundly important tool to protect shareholders from the malfeasance and self-dealing by officers and directors. It is a central tenet of American corporate governance. This form of protection is apparently all but unavailable under Bermuda law.
In addition, there are serious questions about the enforceability of U.S. judgments in Bermuda. There is presently no treaty with Bermuda that ensures the reciprocity of judgments. Thus, a person who has successfully prosecuted a federal securities claim or products liability lawsuit in the United States against the corporation, for example, may be unable to enforce that judgment against the corporation in Bermuda. Bermuda courts have the right to decline to enforce an American judgment if they believe it is inconsistent with Bermuda law or policy. Bermuda may be not just a tax haven, but also a judgment haven.
Finally, a Bermuda incorporation will greatly impede my office or any state Attorney General in protecting the public interest and safeguarding shareholder rights including the state’s financial interests – stopping a shareholder vote, for example, if shareholders are provided with misleading information. Earlier this year in Connecticut, Stanley Works issued conflicting statements to 401k shareholders. The first statement said that failure to vote would be counted as a “no” vote. The second one said that failure to vote would allow the 401k administrator to cast a ballot consistent with the 401k plan. My office, representing the state of Connecticut as a shareholder, filed an action in state court that halted the vote because of the tremendous confusion caused. Whether I could have taken a similar action had Stanley Works been incorporated in Bermuda is at best unclear.
The misstatements made by Stanley Works management were so misleading and potentially deceptive that I requested a full investigation by the Securities and Exchange Commission (SEC) and an order delaying any revote until such an investigation is complete. I further requested that the SEC review the May 28, 2002 Stanley Works proxy statement to determine whether Stanley Works has accurately explained the impact of the Bermuda move on shareholder rights. The SEC expressed interest in reviewing the proxy statement.
As a result of my complaint and SEC interest in this matter, Stanley Works issued a revised proxy statement on June 21, 2002 which was just made available to me this morning. The revised statement contains -- for the first time -- a clear concession by Stanley Works that a Bermuda reincorporation will restrict shareholders’ rights. The revised proxy statement states: “Your Rights as a Shareholder May be Adversely Changed as a Result of the Reorganization Because of Differences between Bermuda Law and Connecticut Law and Differences in Stanley Bermuda’s and Stanley Connecticut’s Organizational Documents.”
I am hopeful that continued SEC pressure – along with legal challenges to the adequacy of similar proxy statements by other corporations proposing a reincorporation in Bermuda -- will compel clearer and more truthful descriptions in proxy statements concerning the severe weakening of shareholder ability to hold management accountable under Bermuda law.
Some corporation proxy statements may seek to assure shareholders that the new corporation bylaws will restore some of these lost shareholder rights. This substitute is simply inadequate. If corporate bylaws were sufficient to protect shareholder rights, we would not need federal and state securities laws.
In sum, reincorporation in another country like Bermuda undermines the interests and rights of American shareholders. Corporate CEOs, whose compensation is typically tied to short-term gains in stock price or cash flow, often gain millions in additional pay stemming directly from the tax savings obtained by these moves and are better able to engage in insider transactions. They are less exposed to shareholder derivative lawsuits and federal securities action. They are shielded from shareholders seeking to hold them accountable for misjudgments or malfeasance. The incentive for corporate officers to make the move to Bermuda is obvious. But the interests of ordinary shareholders and the United States are gravely disserved.
If American corporations seek a more level playing field – fairer tax burdens so they can better compete globally – they at least ought to stay on our side of the field. They ought to pay their fair share of the financial cost of American services and benefits that also aid them. And they should be required to show a specific need or disadvantage compared to some foreign competitor that threatens American jobs or economic interests.
I urge the Committee to first approve legislation that will permanently close this loophole and then determine whether our tax laws need to be changed to address inequity concerns that have been raised. The Treasury Department’s preliminary report listed several areas for review, including rules limiting deduction for interest paid on foreign related debt, rules on valuations on transfers of assets to foreign related parties and cross-border reorganizations. I do not endorse any specific proposal for tax law change, or even necessarily general change itself. What I endorse strongly and unequivocably is the need for closing this destructive loophole, as HR 3884 would do. The measure should be permanent so as to assure credibility and certainty. The status quo is unacceptable.